submitted by
Uric Dufrene, Ph.D., Sanders Chair in Business, Indiana University Southeast
As last year ended, the market was expecting several rounds of interest rate cuts. The Fed alone had indicated it would reduce rates three separate times over 2024, and the market was expecting double that. It was around October of 2023 that Fed Chair Jerome Powell uttered that the Fed was about done hiking rates. Equity markets rejoiced and began a 4th quarter surge. From October 2023 to March 2024, the S&P 500 added more than 300 points, increasing by about 28%. The tech-heavy NASDAQ increased by 30%. Since late March and through April, we’ve seen an abrupt reversal. The S&P 500 trimmed 5.5% and the NASDAQ is already down 7%. The culprit is linked to inflation.
Higher inflation puts upward pressure on the 10-Year Treasury yield, the benchmark for consumer financing costs, including mortgages. In early 2024, the yield had declined to 3.88 percent. After a series of higher-than-expected inflation reports, the 10-Year Treasury yield is almost hitting 5%, closing at 4.61% last week. Higher rates are supposed to suppress demand because it ultimately affects the cost of financing for both business and consumer loans, including mortgages.
After hitting almost 8% for a 30-year mortgage in October 2023, mortgage rates had been on a decline since then and hit a recent low of 6.7% in late 2023. Since the higher-than-expected inflation reports and the upward trajectory of the 10-year Treasury yield, mortgage rates have been climbing since December and have since crossed 7% in April. Excluding the time when rates surpassed 7% late last year, 7% mortgages last appeared in the early 2000s. Rates remaining above 7% will adversely impact building activity, exacerbating the housing supply problem, and placing continued upward pressures on home prices. One of the key reasons for higher inflation is linked to housing, with the last CPI report showing the cost of shelter increasing by 5.7% from the previous year.
Another reason for higher rates is a continued strong economy. Inflation pressures remain, but higher yields are also driven by a very resilient macroeconomy, driven by the consumer. The last retail sales report showed strong continued spending by consumers, placing additional upward pressure on the 10-year yield. While consumers continue to spend, there are emerging signs of distress. Delinquencies on credit cards are the highest since 2012, and consumer loan delinquencies now exceed the pre-pandemic level. Thirty days past due delinquencies for 30-year mortgages have also been increasing since hitting a bottom in June 2021, and are at the highest in four years.
The preferred Fed inflation gauge will be out this month, and the FactSet consensus is for a year-over-year rate of 2.6%, with a core (inflation minus the cost of food and energy) reading of 2.7%. If actual rates come in higher than expected, we can expect significant additional stock market choppiness and additional upward pressures on the 10-year yield. If it is indeed a hotter number, we will see a growing narrative for another rate hike this year, and equity markets will shed additional losses.
What will it take to reverse the recent climbs of the 10-year yield? A weak employment report would be a significant boost to lower rates, along with softer inflation readings. Weaker average hourly earnings increases, along with a reduction in the number of job openings would also work to reverse the climb of the 10-year. All this sounds like bad news, and that is exactly what markets would like to see. Bad news would put the Fed back on a schedule of rate reductions, and markets would rally. The best combination is weaker inflation reports, along with employment that remains resilient. This would put the nation’s economy back on track for a soft landing.
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